Bankruptcy Basics for Attorneys

This is the second of a two-part series to familiarize nonbankruptcy lawyers with basic bankruptcy law concepts and practices. This part focuses on specific aspects of Chapter 7 and Chapter 13 proceedings and provides practice hints.

Bankruptcies in Wisconsin are again on the rise. As a result, more nonbankruptcy attorneys (that is, lawyers who do not focus on bankruptcy law) encounter bankruptcy law in their everyday practices. This article familiarizes those lawyers with the basics so they can effectively represent or defend against parties who have filed a bankruptcy proceeding.

Because of the breadth of the topic, the article is in two parts. The first part, in the March 2011 Wisconsin Lawyer, introduced very basic bankruptcy concepts and practice tips for nonbankruptcy lawyers. This second part deals with common but specific aspects of bankruptcy practice and provides additional practice tips. As with part one, this discussion focuses on the most common bankruptcy proceedings, Chapter 7 and Chapter 13.

Attorney Fees for Attorneys Representing the Debtor in Nonbankruptcy Matters

If a lawyer wishes to get paid from the bankruptcy estate, the court must appoint the lawyer as attorney for the estate.1 This is relevant most often in personal injury actions. If a lawyer represents a client in a personal injury matter and that client files for bankruptcy, the lawyer should contact the trustee as soon as possible and get appointed.

There are additional issues a lawyer representing a debtor in other nonbankruptcy matters, such as a divorce, should be aware of. First, because all the debtor’s property becomes property of the estate upon filing of the bankruptcy petition, if there are funds in a lawyer’s trust account on the day the bankruptcy petition is filed, the trustee may claim those funds as property of the estate. As a result, the lawyer may be forced to surrender the funds if the debtor cannot exempt them. Second, several courts have held that fee agreements entered into before a Chapter 7 filing are not binding after the petition is filed.2 Thus, a lawyer should have the client sign a new fee agreement after the bankruptcy filing to ensure that the fee agreement is legally binding.

Practice Tip: 1) If you know your client may file for bankruptcy, communicate with bankruptcy counsel so you can coordinate the payment of your fees and minimize your risk. Most bankruptcy attorneys are sensitive to this issue and will assist you.

2) Do not ask for payment of a large sum of past-due fees just before the bankruptcy filing. Any payment likely will be deemed a preference (defined below), and it may put your client and bankruptcy counsel in an awkward position.

3) Do not directly or indirectly ask the client during the bankruptcy for payment of past-due fees. This is virtually always a violation of the automatic stay and subjects you to possible sanctions.

4) After the bankruptcy filing, do not ask for payment of pre-petition attorney fees or require payment of pre-petition attorney fees to provide services to the client post petition. Doing either will almost always violate the automatic stay or the discharge injunction (defined below), or both.

5) Do not accept a payment or an advance of fees or costs after the bankruptcy filing unless you can ensure that the funds are no longer property of the estate, because otherwise you may be required to disgorge those payments.

6) To minimize the risk that the payment of your attorney fees and costs will be found to be a preference (defined below), you should do the following:

a) Bill your client monthly and provide in your fee agreement that you may withdraw as his or her attorney if the client does not stay current on payments. If the client does not stay current, give plenty of warning of your intent to withdraw, and then withdraw in accordance with the court and professional ethics rules regarding withdrawal.

b) On receipt of advanced fees and costs, comply with the rules regarding placing advances in your business account so that you can take payment for services as soon as you render them, thereby dating the payment as far in advance of the bankruptcy as possible.

c) If you deposit advanced fees into your trust account, bill your client monthly, give the required five-day notice to withdraw funds from your trust account, and withdraw the funds as soon as you can, so that payment occurs as far in advance of the bankruptcy as possible.

Discharge and Dischargeablity

Most debtors are entitled to a discharge, and most debts are dischargeable. Some debts, such as certain taxes, are nondischargeable automatically.3 Other debts can only be determined nondischargeable if a creditor prevails in an objection to discharge of that particular debt.4 For example, if the debtor obtains a new credit card before filing a bankruptcy using a false financial statement, the lender may file an objection to the debtor’s discharge of that credit card obligation. If the lender is successful, the debt owed to that lender will be deemed nondischargeable, and the debtor will have to pay the debt in full. If an objection is necessary, it must be brought by filing an adversary proceeding, which is basically a lawsuit within the bankruptcy.5

James W. McNeilly Jr., U.W. 1981, has been a Chapter 7 Bankruptcy Panel trustee since 1987 and has occasionally served as an operating Chapter 11 trustee. A substantial portion of his practice is bankruptcy and insolvency matters. He is chair-elect of the State Bar’s Bankruptcy, Insolvency and Creditors’ Rights Section.

Additionally, a debtor can be denied a discharge of all debts under certain circumstances, usually involving the debtor’s commission of some type of fraud on creditors. An adversary proceeding must be brought if total denial of a debtor’s discharge is desired.6 The deadlines for filing an objection to discharge are very short. Typically, an objection to discharge must be filed within 60 days after the first scheduled meeting of creditors unless the court grants an extension to file an objection before the initial time period expires.7 A discharge also may be revoked after it has been granted, again by means of an adversary proceeding. Typically revocation is sought because a debtor has committed fraud in connection with the case or failed to cooperate with the administration of the case.8 The deadline for filing an adversary proceeding to revoke a discharge is one year after the discharge was granted, or the date the case was closed, depending on the grounds for revocation.9

In general, a discharge operates as an injunction against collection from the debtor personally and from the debtor’s property.10 Furthermore, a discharge also enjoins a creditor from collecting, from the community property of the debtor or the debtor’s spouse, an allowable community claim that is not excluded from the discharge.11Communityclaim is defined in 11 U.S.C. § 101(7) and essentially means any claim for which the debtor or both the debtor and the debtor’s spouse are liable. When only one spouse files a bankruptcy case, the discharge injunction is often called the “phantom discharge,” because it protects the interests of both a debtor and a debtor’s nonfiling spouse in community property. However, it does not protect a nonfiling spouse’s individual property, if the nonfiling spouse is obligated on the debt. Nor does it protect the couples’ community property when the marriage is terminated by divorce or the death of one of the spouses.12

Another unusual aspect of single-spouse bankruptcy filing is that an adversary proceeding in which an objection is made to the dischargeability of a debt incurred by a debtor’s nonfiling spouse must be filed within the same time limit as an objection against the debtor.13 This often is called a “hypothetical discharge.”14

Practice Tip: Generally, a failure to meet the deadline to file an objection to discharge cannot be remediated. Therefore, if you represent a creditor, you must determine early on if there are grounds to object to a debtor’s discharge and whether it is necessary to file an adversary proceeding to determine dischargeability and if so, what are the timelines. Furthermore, creditor’s attorneys must pay special attention to the bankruptcy filings of both the debtor and the debtor’s spouse because of the phantom and hypothetical discharges.

Proof of Claims

In Chapter 7 asset cases and in all Chapter 13 cases, creditors must file a proof of claim to receive distributions from the bankruptcy estate.15 There is a deadline to file a proof of claim (the “claims-bar date”) in both Chapter 7 and Chapter 13 proceedings. The bar date is set forth in the notice of meeting of creditors, which the court mails to all interested parties shortly after a petition is filed, or in a subsequent notice that the court sends to all interested parties once it has been determined that funds will be available for distribution. A proof of claim is timely filed if it is filed within 90 days of the first scheduled meeting of creditors or, if the creditor is a governmental entity, within 180 days of the first scheduled meeting.16

Generally, in a Chapter 13, if a claim is not timely filed, it will not be allowed and the creditor will not receive any proceeds from the bankruptcy estate.17 In a Chapter 7, timely filed claims have priority over claims that are filed late. Because usually there are insufficient funds to pay all claims in full in a Chapter 7, timely filed claims are rarely paid in full and late-filed claims often are paid at a lower rate or not at all.18

Practice Tip: It is imperative that a proof of claim be filed on time. If you or your creditor client has actual knowledge that a bankruptcy has been filed, you are on notice of the bankruptcy and are required to file a claim by the deadline so as to have the client’s claim be treated equally with other timely filed claims.19 Even if you or your client did not receive a notice of meeting of creditors or were not listed on the debtor’s schedules, if you have actual knowledge that a bankruptcy was filed, you are also considered to have actual notice of the filing and, as a result, you have a duty to determine what the claims-bar date is and to comply with it. Thus, if you are retained to represent a creditor in a bankruptcy, you must immediately determine the claims-bar date. If your client discovers that a bankruptcy has been filed after the claims-bar date has passed, it is possible for the claim to be allowed with the same priority as timely filed claims, provided that you immediately ask the court for leave to file a claim and that the claim be allowed as timely.

Reaffirmation Agreements

Many debtors owe debts that are secured by personal property, such as automobiles, that they desire to keep. There are several means by which a debtor may retain these assets, but the most common method is reaffirmation. Reaffirmation results in a new agreement to continue paying a dischargeable debt, such as a motor vehicle loan, after the bankruptcy, usually for the purpose of keeping the collateral that secures the debt. A reaffirmation agreement must be filed before a debtor receives a discharge,20 and a debtor has 60 days from the filing of the agreement to rescind it.21 If a reaffirmation agreement is properly executed and filed, the debt is treated as if the debtor had not filed a bankruptcy. Thus, if the debtor later defaults on that reaffirmed obligation, the creditor can repossess the collateral and sell it. If the collateral is sold for less than the amount due, “the deficiency,” the creditor can pursue the debtor for repayment of that deficiency.22

Practice Tip: Representing a creditor with regard to a reaffirmation agreement is a relatively simple matter, although the details of the exact procedure to follow are beyond the scope of this article. Reaffirmation agreement forms can be found on the websites of the Western District and Eastern District of Wisconsin Bankruptcy Courts (see the accompanying resource sidebar). If you represent creditors with regard to reaffirmation agreements, make sure to become familiar with 11 U.S.C. § 524 and Federal Rule of Bankruptcy Procedure 4008.

Motions for Relief from the Automatic Stay and Abandonment

The automatic stay is explained in detail in part one of this series. Penalties for violating the automatic stay are severe. They include actual damages, including costs and attorney fees, and under some circumstances punitive damages.23 Because the automatic stay becomes effective immediately on filing,24 even if a creditor has yet to receive notice, it is imperative that creditor’s counsel check PACER (Public Access to Court Electronic Records) before proceeding with a foreclosure, replevin, or any other collection action to ensure the debtor has not filed bankruptcy. It is not uncommon for a debtor to file a bankruptcy the day before, or even the morning of, a sheriff’s sale in a foreclosure action, a hearing on a motion for default judgment, or a hearing for summary judgment.

In both Chapter 7 and Chapter 13 proceedings, for actions not involving property of the estate, the stay usually terminates when a debtor receives a discharge or the case is closed or dismissed, whichever occurs first.25 However, the stay may terminate sooner if a creditor prevails on a motion for relief from stay.26

In a Chapter 7, the date of termination of the stay for actions against property of the estate depends on whether the trustee is administering any of the assets the stay protects. In a no-asset Chapter 7, meaning there are no funds available for distribution to creditors, the stay terminates when the case is closed.27 In a Chapter 13, the stay terminates with regard to the property of the estate when the case is dismissed or closed.28

Summary of Part One: Bankruptcy Basics for Attorneys

Part one of this two-part series appeared in the March 2011 Wisconsin Lawyer and focused on basic bankruptcy concepts and practice tips. The following summarizes the issues covered in part one.

• Chapter 7: This is the bankruptcy procedure that typically comes to mind when one thinks of bankruptcy. It often is referred to as a straight liquidation.

• Chapter 13: This procedure generally allows a debtor to keep all of his or her assets and pay debts over time.

• Issue Spotting: With bankruptcies on the rise, nonbankruptcy lawyers need to be able to identify situations in which it is appropriate to consult with a bankruptcy attorney on his or her own behalf or on behalf of a client. For example, individuals who are divorcing who have significant marital debt should consult with a bankruptcy attorney before finalizing a divorce because there may be a significant benefit to both parties to file jointly for bankruptcy.

• Eligibility: Virtually all debtors with mostly consumer debts are eligible to file a Chapter 7; debtors with mostly consumer debts are eligible if they pass the means test and the totality-of-circumstances test. Only individual debtors with debt below certain debt limits are eligible to file a Chapter 13.

• Forms: A bankruptcy is commenced by filing a petition; a debtor also must file Schedules A-J and a statement of financial affairs and provide other documents to the trustee. A Chapter 13 filing also requires a plan.

• Property of the Estate: Virtually all assets owned by a debtor on the date of filing immediately become the property of the bankruptcy estate.

• Exemptions: A debtor has the right to protect certain assets using exemptions that protect property from being liquidated to pay debts.

• Automatic Stay: The stay is effective immediately on filing a petition, even without notice, and enjoins most actions against the debtor and the debtor’s property.

• Meeting of Creditors: Also known as the section 341 meeting, the meeting of creditors is held not less than 20 and not more than 60 days after the bankruptcy is filed.

• PACER and Electronic Filing: All attorneys should have PACER (Public Access to Court Electronic Records). It allows users to obtain case and docket information from federal courts, including bankruptcy courts, from anywhere Internet access is available.

• Eastern and Western Districts: Even though federal law controls bankruptcy, there are significant differences between the districts in how some issues are handled.

• Pre-bankruptcy Planning: Such planning is allowed but it is dangerous if not done properly: a debtor’s bankruptcy can be dismissed, or a debtor can be denied a discharge or even go to prison.

Furthermore, relief from the stay does not remove property from a bankruptcy estate. Thus, if a creditor wants to take action against property of the estate, such as continuing with a foreclosure action, the creditor also must obtain an abandonment of the asset. A trustee will abandon an asset if administering the asset will be of no benefit to the estate (for example, if the liens against a piece of property exceed its value). Abandonment may be obtained by making a motion.

Practice Tip: Many creditors do not bring relief-from-stay and abandonment motions in Chapter 7 proceedings because most are no-asset cases. In a no-asset case, the stay terminates when the discharge is granted and the case is promptly closed. When the case is closed, creditors are allowed to proceed without the court’s permission. Thus, it may be more cost effective for your creditor client to wait until the case is closed to pursue collection rather than to file a motion for relief or abandonment.

If a motion for relief from the stay and a motion for abandonment are necessary, the motions may be made in the same document. When making a motion for relief and abandonment in either Chapter 7 or Chapter 13, it is important to include sufficient information for the trustee, the debtor, and the court to evaluate the motion. Usually the note, any assignments, the recorded mortgage, title insurance showing the mortgage’s priority, evidence of amounts due on prior liens, evidence of default, and a real estate tax bill or appraisal to indicate value should be included. The court also may require an accounting. Finally, if the debt is a consumer debt, the creditor must comply with the notice requirements of the Fair Debt Collection Practices Act.

Chapter 13 Practice Tip: If the purpose of a Chapter 13 is to reinstate a mortgage, the court is not likely to grant a motion for relief filed soon after the bankruptcy filing if the pre-petition mortgage arrears will be paid through the Chapter 13 plan. However, if a debtor fails to make postpetition mortgage payments, a creditor may wish to move for relief and abandonment. In both the Eastern and the Western District bankruptcy courts, these motions often are settled on the following terms: the delinquent payments, late fees, and attorney fees for the motion are added together to determine the total amount of the delinquency, and either the debtor is granted some time to pay that delinquency, or the delinquency is added as a separate claim to be paid over the remaining term of the plan, which is amended accordingly. Additionally, the creditor often insists on a “doomsday provision,” stating that if the debtor fails to timely make any regular monthly mortgage payments during a limited time (usually six to 12 months), the creditor is automatically entitled to relief and abandonment.

Preferences

Preferences, which are governed by 11 U.S.C. § 547, can take many forms. For example, the granting of a mortgage or obtaining of a judgment against a debtor could be a preference. However, the most common type of preference is a payment made to an unsecured creditor because the creditor receiving payment is being “preferred” by the debtor. Essentially, a debtor cannot pick and choose which creditors will get paid and which creditors will not. A payment to an unsecured creditor may be considered a preference if it was made within 90 days before filing a bankruptcy.29 This 90-day time period is called the lookback period. If a creditor is an insider, meaning a family member or friend, the lookback period is one year.30 For example, a debtor’s parents borrowed $100,000 from a bank and loaned the funds to the debtor. In the year before filing bankruptcy, the debtor has paid $400 a month directly to the bank, therefore reducing the balance of the parents’ obligation to the bank. Those payments to the bank constitute a preference. If a payment is determined to be a preference, the creditor that received the preference could be required to disgorge those funds to the trustee. Any funds recovered from a creditor become property of the estate.

However, many defenses are available to a creditor that received what appears to be a preference,31 such as, 1) the payment or transfer was a substantially contemporaneous exchange for “new value” (meaning money or goods with value), 2) “new value” was given to the debtor after the payment or transfer,32 3) the payment or transfer was made in the ordinary course of business according to ordinary business terms,33 4) the payment or transfer was in good-faith and related to a domestic support obligation,34 5) the payments or transfers within the lookback period total less than $600 and the debtor is an individual with primarily consumer debts,35 or 6) the payments or transfers within the lookback period total less than $5,850 and the debtor’s debts are primarily business debts.36

Practice Tip: A creditor might be able to settle a preference claim for substantially less than the claim amount. Because a preference action must be brought by an adversary proceeding and there are many defenses available to creditors, the trustee might not be able to recover the entire amount of the claim without incurring substantial legal fees. Thus, often it is more beneficial to the estate for the trustee to settle preference claims than to litigate with creditors to recover the funds.

Fraudulent Transfers

Generally, fraudulent transfers are certain types of transfers by a debtor before filing that diminish the bankruptcy estate.37 The term fraudulent transfer is somewhat of a misnomer, because some types of transfers are considered fraudulent even if there is no element of fraud. Most typically, fraudulent transfers are conveyances to insiders for no or less than full consideration, made within two years before filing of the bankruptcy petition.38 For example, the debtor owns a cabin with his brother. There is a small mortgage and approximately $60,000 of equity in the cabin that the debtor cannot exempt. The debtor’s business is starting to struggle and bankruptcy is on the horizon. As a result, the debtor transfers his one-half ownership interest to his brother for no consideration 14 months before filing a Chapter 7. Clearly, in this scenario, the debtor did not receive full consideration, or any consideration for that matter, and the transfer is fraudulent. If a transfer is found to be fraudulent, the trustee has the power to void the transfer, recover the asset, and liquidate it for the creditors’ benefit.39

Granting Credit to a Debtor

The court must approve any credit granted to a debtor in a Chapter 13.40 Although credit granted to a debtor in a Chapter 7 does not have to be approved, the debtor’s assets may be property of the estate. Thus, a creditor taking a lien on a debtor’s property must ensure that the property is no longer property of the estate, or the lien might not be valid.41

Student Loans

Student loans, which are broadly defined in the Bankruptcy Code, are not dischargeable unless “excepting such debt from discharge … would impose an undue hardship on the debtor and the debtor’s dependents.”42 The definition of undue hardship is not unanimously accepted, but the majority of the federal circuits have adopted the following three-prong test. First, the debtor cannot maintain, based on current income and expenses, a “minimal standard of living for [himself or herself] and [his or her] dependents if forced to repay the loans.” Second, additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the student-loan repayment period. Third, the debtor has made good-faith efforts to repay the loans.43 In practice, this three-prong test is difficult to meet, because to satisfy the second prong, the Seventh Circuit requires that “the dischargeability of student loans should be based on the certainty of hopelessness, not simply a present inability to fulfill financial commitments.”44

Domestic Support Obligations

The Bankruptcy Code distinguishes between domestic support obligations (DSOs) and nondomestic support obligations (non-DSOs) in the context of obligations relating to paternity actions, divorces, and separations. Generally, DSOs are defined as debts 1) owed from or to a spouse, former spouse, child, child’s responsible relative, or governmental unit; 2) that are “in the nature of alimony, maintenance, or support”; and 3) that result from a court order, a determination made by a governmental unit, or a separation agreement, divorce decree, or property settlement agreement.45 Notably, DSOs include obligations incurred postpetition, interest, and debts voluntarily assigned to governmental entities.46 Furthermore, despite whether an obligation is expressly designated to be “in the nature of alimony, maintenance, or support,” it still may be determined to be a DSO.47 In practice, bankruptcy courts broadly define DSOs. For example, guardian ad litem fees incurred in a family law matter have been held to be a DSO, even though it is arguable that they should not be, because they are not, strictly speaking, “in the nature of alimony, maintenance, or support.”48 Non-DSOs are debts incurred by the debtor in the course of a divorce or separation that are not DSOs.49

For example, during a divorce the wife agrees to pay one credit card bill, which has a balance of $250, and the husband agrees to pay the remaining credit card bills, which total $75,000. In consideration, the wife also agrees to receive a reduced monthly support payment. In the marital settlement agreement, both agree to hold each other harmless for their respective debts. The wife’s obligation to pay the single credit card bill is likely to be deemed a non-DSO. However, the husband’s obligation to his wife to pay the remaining $75,000 of credit card debt is likely to be deemed a DSO because the obligation is in the nature of alimony, maintenance, or support based on the wife’s agreement to receive lower support payments in return for the assumption of those debts and she likely will not have sufficient income to pay those debts herself.

In addition, DSOs are not dischargeable under any chapter of the Bankruptcy Code. Non-DSOs also are not dischargeable under any chapter, except for Chapter 13, and only under certain circumstances.50 Therefore, it is not necessary to object to the discharge of any DSO or non-DSO, except for a non-DSO in a Chapter 13.

Finally, DSOs are not subject to a debtor’s claim of exemptions.51 For that reason, some bankruptcy attorneys advise debtors not to file for bankruptcy, because the trustee or a DSO creditor can force the liquidation of an otherwise exempt asset to pay a DSO.

Conclusion

Bankruptcy filings are increasing in number and the rate of filing will likely continue to rise given the current state of the economy. A bankruptcy filing’s implications can be far reaching to creditors, debtors, and even seemingly uninvolved parties. It is prudent for all attorneys to have at least a basic understanding of bankruptcy to properly advise clients and to spot potential issues. If an attorney is faced with a complex bankruptcy issue, it is advisable to work with, or refer the matter outright to, an experienced bankruptcy attorney.